Costs are amounts incurred by the business in producing goods or services. A business has to keep a record of all the costs or expenses associated with its operations. Examples of costs include the cost of machinery, rent, insurance of building, interest on loan and cost of raw materials.
Why do businesses keep records of their costs?
A business uses past cost data to estimate what costs would be in the future. Managers work towards not exceeding the budgeted cost in order to achieve the overall corporate objective.
A company would normally compare the actual cost incurred from the company’s records with budgeted costs to ascertain the variances. The reason for the variation is analysed and corrective actions are taken. For example, actual costs may exceed budgeted costs due to wastage from inefficient machines or unrealistic budget.
The profitability of a product or the entire factory is ascertained by evaluating the difference between total sales revenue and total costs. The profit will assist investors to assess the return on their investment and determine whether it is worthwhile to invest in the business or explore alternative investment opportunities.
The cost data help managers set a selling price by adding a targeted profit to the costs incurred. This method of adding a certain percentage to the cost to arrive at the selling price is known as cost-plus pricing. For example, the selling price of a product will be $11 if 10% is added to the total cost 0f $10, i.e. $10 + $1 (10% of $10 is $1).
Comparison with the past
It enables comparison with the past to determine the efficiency of a business, operation or product. Cost increases will, no doubt, depress profit margins; so a rising cost over time may require sourcing for cheaper materials, raising the selling price or embarking on other cost-cutting measures. Below-average profit margins discourage investment and can result in losses if not controlled in time.
Direct and indirect costs
Direct costs are costs that can be traced to a particular activity, department or equipment. These costs are involved directly in making a product and can be allocated to each unit produced. The three major types of direct costs are direct labour cost, direct material cost and direct expenses. Direct material cost is the cost of raw materials; wages of factory workers is an example of direct labour cost; direct expenses are identifiable with each unit of the product and are direct consequences of production, e.g. royalties, cost of hiring production machine, the maintenance cost of manufacturing equipment, etc.
Indirect costs cannot be traced to a particular activity, department, service or equipment. Indirect costs are also known as overheads. They are incurred in the production process but cannot be traced directly to each unit of the product produced, eg. insurance, salaries of supervisors, and administrative expenses.
Fixed and variable costs
Fixed costs are costs that remain unchanged within the period regardless of changes in the output level. They are incurred even if the output is zero, e.g. salaries, insurance and rent. Fixed costs are also known as overheads.
Variable costs are costs that are directly related to output level. They will increase if output increases and decrease if output decreases, e.g. cost of raw materials. In reality, there are some costs that are both fixed and variable; these are called semi-variable costs.
The addition of fixed cost and variable cost will give the total cost. The average cost is the cost per unit and is obtained from the division of total cost by the number of units made. Marginal cost is the cost of producing one more unit of a product, i.e. change in total cost arising from manufacturing an extra unit of a product.